Turbulent Exit Redux

A lot of people have speculated about what would happen when the Fed raised rates, and almost all of them have been surprised.

One of them is Zoltan Pozsar, who boldly went on record with the view that corporate cash pools of various kinds would shift out of bank deposits into government-only mutual funds, which would invest the funds in the new Fed RRP facility, so shifting the balance of Fed liabilities from reserves to RRP.

So far that hasn’t happened, and in an important new paper Pozsar tries to understand what did happen instead, and why.

There has been $100 billion shift out of bank deposits, but that is much smaller than expected, and most importantly it hasn’t shown up in the new Fed RRP facility at all. Pozsar’s main question is, Where did those funds go?

(A subsidiary question is whether even $100 billion is enough to force some banks to reallocate their HQLA portfolio, selling Level 2 and buying Level 1 assets, perhaps harbinger of bigger things to come. Pozsar suggests that it might be, but I leave that aside.)

Another thing we know is that the balance of Fed liabilities has shifted, out of reserves and into both the Treasury General Account and the RRP facility that the Fed offers to foreign central banks. Most the former happened before the hike, but the latter is a new thing to the tune of $220 billion.

Pozsar’s idea is that we should connect these dots.  Corporate cash pools, he thinks, are shifting out of bank deposits as expected, but they are shifting into Treasury bills not government-only mutual funds. And the source of those Treasury bills is first the Treasury itself (issuing bills to fund its TGA account) and second foreign central banks who are shifting out of Treasury bills into Fed RRP.

So far as I can see, this is a guess not a fact, since we don’t have contemporaneous data on cash pool holdings, only on the Fed balance sheet numbers.  And it should be said that there are other things that could be causing the numbers we observe, for example flows rather than portfolio shifts.  When I paid my quarterly estimated tax in January, that reduced my Citibank deposit account and increased the Treasury’s TGA account without putting any new Tbills into circulation. Similarly, it is at least possible that foreign central banks are accumulating reserves out of official balance of payments surplus, perhaps putting them in RRP rather than Treasuries because the Fed is offering a higher yield.
But let us entertain the Pozsar Hypothesis and see where it goes.  The style of analysis certainly has a lot to offer, using the discipline of accounting to spin a possible story.

Pozsar thinks it’s all a plot of the FOMC: “In the end, the Fed’s long-standing aversion to money funds (whether prime or government-only) seems to have dominated the FOMC’s thinking.”  Instead of allowing markets to take their natural course (i.e. “Turbulent Exit“), the FOMC somehow got the Treasury and foreign central banks to sell Treasuries to the cash pools directly, and then to transfer their proceeds to the Fed, which caused the shifting liability balance.

The problem with this story is that there are other deciders in the room.  Maybe it was foreign central banks responding to volatility in the Treasury market, realizing that the RRP facility is a superior reserve in times of trouble, and the interest on RRP was just a bonus. Maybe the Treasury has its own reasons to want to help the Fed reduce its reserve exposures.  Surely I am not the only one who recalls the kerfuffle when Bernanke floated the trial balloon that the Fed might issue its own F-bills, in competition with T-bills. The Treasury did not like that one.  The RRP facility is not an F-bill, but even so it definitely competes with T-bills, and that cannot make the Treasury completely happy.

Be that as it may, Pozsar is absolutely right to emphasize that both the Treasury balances and the foreign central bank balances are naturally limited.  If there really are a trillion dollars of corporate cash pools out there that are going to shift out of bank deposits into something else, not to mention the shift from soon-to-be floating NAV prime funds, then Pozsar’s original scenario remains on the table as a possible future.  Maybe it is just early days, or maybe it is happening but has been swamped by confounding effects coming from elsewhere.

Others have also noticed the foreign RRP number, and wondered about it, going so far as to suggest that foreign central banks are somehow helping the Fed to raise rates, but I’m not convinced.  The problem is that foreign RRP is not an asset available to any market participant, only to central banks who are under no obligation to pass that rate along to their own depositors (indeed, most are easing while the Fed is tightening).

We remain in uncharted waters.  It is a good time to be a money watcher.



9 comments on “Turbulent Exit Redux

  1. Or maybe the reserve money has simply been retired, or destroyed, over the last few months? The inverse of money creation.

    The latest estimates are that at least $1 trillion in EM forex reserves have been sold in the past year, probably much of it to retire eurodollar liabilities in the pool where a similar amount of reserves have been parked for the past year.

    As Jeff Snider posits at Alhambra, there is evidence of huge contraction in the credit-based eurodollar market. No new lending, no new reserves. Repay loan, destroy money.

    Throw in a few defaults and bond write-downs and margin contraction from $16 trillion in lost global market-cap, soon we’re talking about a pile of missing money!

    Foreign CB preference for using RRP could be explained by liquidity concerns – the PBOC to fight the marauding hedge funds – and the mistaken belief the Fed was doing the right thing and long bonds would fall, not rise in defiance of Fed optimism.

  2. Perry Mehrling on said:

    The total Fed balance sheet is more or less exactly what it was a month ago, you can compare at http://www.federalreserve.gov/releases/h41/. So no Fed liabilities have been destroyed, only changed form and ownership. Which is not at all to deny the other forces you mention, since for most people what matters is their bank deposit, not their Fed deposit!

  3. There is no way that “the Fed’s long-standing aversion to money funds (whether prime or government-only) [would] have dominated the FOMC’s thinking.” As you can see from the transcripts, the FOMC doesn’t say or think one thing in private, and rationalise it with an entirely different explanation in public. I think most can see why that would be a terrible idea (what if your false rationale starts mis-behaving, relative to your real rationale).

    Having said that, it might be an attractive theory to somebody from the outside looking to explain why they were wrong.

  4. In theory, isn’t it possible that demand for the Fed’s RRP facility would be so large that the Fed’s portfolio of Treasuries would not be able to accommodate it, i.e. the Fed will run out of collateral? If I understand correctly, the entire money supply M2 could potentially move into the RRP facility, and this is much bigger than the Fed’s stock of assets.

  5. Perry Mehrling on said:

    If that happens, the Fed could buy more assets by issuing more reserves, and then use those assets as collateral for RRP, so swapping one liability for another. This would expand its balance sheet on both sides.

    • I’m not sure the Fed would be happy to expand its balance sheet at this point, but I guess that’s how it would work. Thanks.

  6. “Another thing we know is that the balance of Fed liabilities has shifted, out of reserves and into both the Treasury General Account and the RRP facility that the Fed offers to foreign central banks.”

    According to http://www.federalreserve.gov/releases/h41/Current/, reserve balances are $2.4 trillion; the Treasury General Account and RRP facility combined total a little over $0.6 trillion. How is this a shift in the balance of Fed liabilities? Reserves are four times greater.

    • I see that in summer 2014, Reserves were up to $2.8 trillion, so they’ve been going down, and the foreign part of the RRP has increased by a couple hundred billion since then as well. Thus the shift, I reckon. Maybe the balance of liabilities since 2014 has shifted?

  7. Prof. Mehrling,

    Maybe our errors or inability to fully understand what’s going on lies in our fundamental assumptions in the way we view our financial system. From my understanding, money creation is the most decentralized it’s been since probably the JP Morgan era.

    In our financial system, anyone can basically pick and choose the kind of money that they wanna use. In other words, I essentially think what we have in our financial system is about as close to free banking as you’re gonna get while still having a standard unit account of account with centralized currency issuance. In a financial system like this, the impacts of raising money market rates are incredibly complex. I expected the monetary base to fall quite a bit, but of course that hasn’t happened at all. The Fed’s balance sheet hasn’t contracted significantly if at all, which obviously means my intuition was incorrect.

    I was looking through some data and tabulated some basic facts. The total assets of the American commercial banking system are ~$15.69 trillion as of February 10, 2016 while nominal GDP was ~$18.13 trillion. So the total assets of the American banking system comes out to ~86% of GDP. However, the total market capitalization of listed equity companies in the US in 2014 was ~$26.33 trillion or 152% of GDP in 2014. I’m not able to find data for 2015 or 2016, but I’m willing to bet that the total market cap of listed equity today is ~$30 trillion (maybe less).

    So we live in a financial system where the market cap of listed equity markets is almost double the size of the total banking system. We live in a system where anyone can basically open a brokerage account and start playing around with whatever assets they want ranging from equity to debt to short term bills like commercial paper or Treasuries. So our financial system operates very differently than from what we’ve seen over the past 100 years.

    Am I saying that I understand how our financial system works? Of course not. I can speculate as to how I think it will work, but that would be nothing more than mere speculation. I’m just saying that in terms of developing an analytical framework to think about this, we may really need to go back to the drawing board on this issue.